Big European electricity utilities are facing an existential crisis. How did this happen and what should they do?
For most consumers, the revolution that is taking place in the energy markets has been hidden from view. They still get reliable electricity from the grid, with which to power their homes and businesses. Everything seems the same. Behind the scenes, however, the world is changing rapidly and electricity utilities - the centralised power companies that provide much of the electricity - and grid operators - the companies that transmit and distribute that centralised power - are reeling like battered boxers in round 9 of a heavyweight boxing championship. Some will make it. Others will be knocked out.
In this article History Future Now explores why European utilities got into such trouble and looks to cellular evolution - specifically the endosymbiotic ("endo" = inside + "sym" = together + "biotic" = life) relationship of mitochondria inside a eukaryotic ("eu" = easily formed + "karyo" = nucleus or kernel) cell - to map out a path that some utilities might be able to take in order to survive.
First, where are we now? Most big European electricity utilities are in deep trouble and their share prices have collapsed over the past 10 years. Some of the biggest players, such as EDF, RWE, E.ON, ENEL, Iberdrola, are trading at 90%-50% below their highs of a few years ago. A few, such as DONG and SSE are doing relatively well. They are exceptions and there are some possible explanations as to why they are doing relatively well, which HFN will go into in a subsequent article.
Historically, the utility business was relatively stable. Many utilities started off as private companies and then ended up being owned by the government as monopolies or quasi monopolies. In 1947, for example, the UK government nationalised the UK’s 505 separate electricity generation and supply companies. Their business models included ownership of the power generating assets, the distribution system and managing customer relations. They were predictable and rather boring.
This changed in 1990-1991 when the UK privatised its electricity sector. This unleashed a series of changes in the sector: a lot of natural gas power stations replaced coal power stations and these new plants were financed using bank debt rather than equity provided by the state. After a brief period of successes, many of the UK utilities were snapped up by European utilities who remained either partially or wholly state owned.
In the mid 2000s a number of European utilities moved heavily into the renewables sector, developing, building and operating wind farms. This made a lot of sense - the price for selling electricity generated by wind energy was typically fixed and higher than electricity produced from conventional power stations. This resulted in higher returns with lower risk.
Other energy players, like the oil majors, also tried to get into the act and developed renewable energy businesses of their own. But the stability of renewable energy revenue streams started to attract other players from outside the energy sector - infrastructure funds, insurance companies and pension funds - who were able to buy wind assets at lower cost to the utilities and the oil majors. They were able to bid on large portfolios of built wind assets from the utilities who sold them on at a great, short term, profit.
By the mid 2010s, when large scale solar projects became popular, these non traditional energy players started to dominate the market for the ownership of renewables assets. Most of the new electricity generating assets built over the past few years in Europe have been renewable assets and not coal or natural gas power plants.
So European electricity utilities are in trouble. Their asset bases are dominated by coal and natural gas power stations, which are major contributors of green house gasses. They know that coal is increasingly uncompetitive. Not only are new coal power stations more expensive than new renewables (which is one of the reasons why it was so easy for all of the major European utilities to publicly declared that they will cease to build any new coal power plants after 2020) but their existing plants are likely to face additional restrictions, due to pollution and climate change concerns.
Compounding the cost and pollution issues is the fact that many investment funds, who own shares in utilities, have announced plans to divest themselves from companies that own coal power plants. This reduces the supply of possible buyers of shares, reducing the share prices of those utilities. As a result, a number of European utilities have been trying to dump their coal assets as fast as they can. At the end of 2015 / early 2016, two of the biggest European players, RWE and EON, announced that they would split themselves into two companies - a coal and nuclear business and a renewables-plus-everything-else business. In 2017 DONG, of Denmark, announced that it would divest itself of its coal generating assets.
So this is a problem that has no easy solution. If renewables are going to be dominated by investment funds such as infrastructure funds, insurance companies and pension funds, and coal assets are going to be shut down or sold off to specialist infrastructure funds, the activities set of conventional European utilities looks increasingly small. They are left with some natural gas power stations, some renewable assets that they have not sold, some grid management activities including peaking plants and a customer facing business.
This is not sustainable. While the carbon footprint of natural gas powered plants is not as bad as coal it does not take too much imagination to think that natural gas plants will suffer the same regulatory and share restriction challenges as coal power plants. (While natural gas produces less carbon dioxide than coal per kilowatt hour of electricity produced, there is significant evidence to show that the extraction and distribution of natural gas (methane) results in huge volumes of methane being leaked into the atmosphere. Since methane is 21 times more potent as a greenhouse gas as carbon dioxide this is a problem.) The distribution business is not a great business to be in. Utilities do not have a great reputation for customer care and other players are trying to take that business. Once enough investors understand that utilities are dead men walking the share price of utilities will drop even further, making it harder for utilities to come up with a viable path to future success.
One solution is symbiosis
Fortunately, there are a few options for utilities. One is symbiosis, which we will explore in this article. First, it is important for electricity utilities to understand that from an investor’s perspective the generation, distribution and sale of electricity is a byproduct of what investors are really interested in: the utilities’ ability to generate reliable dividends.
Like the water companies and oil majors, electricity utilities have provided investors with a reliable dividend income every year of roughly 2% - 5% per annum. Why? Simply put, people can't survive without water, heat and electricity. They are the last things that a household will cut in the event of an economic downturn. In addition, the structure of utilities leads them to be natural monopolies, reducing the likelihood of competitive pricing that will reduce the company’s income. (At least this was the case historically. Decentralised renewables are having a major impact on daytime electricity pricing.)
Reliable dividends are highly sought after by retired people and their proxies, such as pension funds, as a source of income. This is the reason why infrastructure funds and pension funds have found owning renewable assets so appealing. After costs, they are able to provide their clients with similar returns of 2-5% per annum, whilst owning the underlying asset, which reduces risk. They are cutting out the utility as the middleman. This is an important insight. Funds want the yield generated by utilities, but do not have the management knowledge of how to run a complex business. They don’t know how to develop, manage the engineering, procurement and construction of new power assets and don’t know how to maintain and operate them once built. They also don’t know how to manage the trading of electricity produced by operational assets. This represents a massive opportunity for utilities, since they DO know how to do these things: it is part of their core institutional knowledge. They should become part of a symbiotic business model between utilities and infrastructure and pension funds.
What is symbiosis?
Symbiosis occurs all the time in the natural world. It means “living together” and refers to two living organisms that live together to the mutual advantage of both organisms. Clownfish - think Finding Nemo - and sea anemones are a good example. The sea anemone, which has stinging tentacles, provides protection to the clownfish and the clownfish provides cleaning services to the sea anemone plus scares away butterfly fish that like to eat sea anemones. The impala and the red billed oxpecker bird are another good example. The impala is a host for tics, which the bird loves to eat, and the bird gets rid of the tics, which the impala can't get rid of on their own.
The most important symbiotic relationship in life, however, occurs inside our cells. This relationship is called endosymbiosis which is like the symbiosis described above but has "endo" meaning "inside" as a prefix. All large multicellular life forms are based on eukaryotic cells. Inside our eukaryotic cells are mitochondria, which provide our cells with the ability to generate 10 times more energy per glucose molecule that we would be able to do otherwise. Mitochondria have their own DNA which is separate and different to the DNA in the main part of the cell. At some point in the evolution of life mitochondrial cells were absorbed by our cellular ancestors and started a perfect symbiotic relationship- they provided more energy to our cells in return for a low risk environment for them to live in. Large multicellular life would be impossible without the extra energy produced by mitochondria. This process is really fascinating and HFN recommends reading Nick Lane's book "The Vital Question" if you want to find out more.
How would symbiosis work in the context of utilities and infrastructure and pension funds?
Like mitochondria, pension funds want a simple life: to provide their customers with 2-5% yield income every year. They want low risk and so would be keen to also own the underlying assets. In return, they can provide significantly more capital than utilities could generate on their own. So here is how the symbiotic relationship between a utility and a pension fund would work from the perspective of the pension fund: the mitochondrion in the relationship. Step one, is an asset transfer to the pension fund in return for being able to manage the assets and cash for the utility:
The pension fund buys all of the generating and distribution assets from the utility. This does not just include renewable assets, which are likely to have a fixed price component, but also its conventional power assets. This generates a one off cash boost to the utility and the pension fund can become the underlying asset owner, providing it with an asset that it could sell in the future, thus reducing their risk.
The pension fund enters into a long term operations and management agreement with the utility to manage the assets it has just bought. The agreement will be for the life of the assets and will provide the utility enough of a return to cover all costs.
The pension fund enters into a long term power purchase agreement with the utility for all of the electricity generated by the assets that the utility operates on its behalf.
In the meantime, the utility can now focus on its unique and core skills. The utility is the eukaryotic cell in the relationship.
The utility can manage the assets on behalf of the pension funds. This is a cost recovery business.The utility can trade the electricity generated by the assets that they manage. This should be a highly profitable business.
The utility is required to provide the pension fund with a yield of 2-5% per annum. They can do this by managing the costs of the assets and the trading of electricity.
The utility gets to keep the return above 2-5% to do with what it wills. This means that the return on capital employed (ROCE) by the utility will be extremely high and they can use the cash from the sale of the assets to buy, develop, design, build and then transfer new assets to pension funds.
What should a utility do with the money it just raised from the sale of its assets?
A lot of other utilities will continue to sell their coal assets. Our utility should use some of its money to secure the rights to these coal assets and then finance them using investment fund money. It should then enter into the same operations and maintenance plus power purchase agreements with the investment fund as it did with its own assets. The larger the asset base it controls the easier it will be to trade electricity and maximise its return on that portion of its business.
Invest in customer relationship management systems. This could either be done through investing in your own customer relationship management system or buying into a new company that can do it better. The better you can manage customer charging and supply and demand the better you can manage your trading business.
It should develop, design, co-finance, build and operate new generating assets with the same arrangement with an investment fund. This could range from large offshore wind farms and solar farms to large battery storage units. The focus should be on assets that can balance its portfolio to make the electricity trading business more profitable with lower risk.
Invest in electric vehicle charging networks. Electric vehicles are going to replace petrol and diesel vehicles. Electricity utilities are in a much better place to benefit from this transition than oil majors are. They should use some of their cash to buy some of the early electric vehicle charging companies and to also develop their own capacity to do this. By owning the network from generation of electrons to car charging stations it will be able to balance its portfolio and trading position more effectively than if it is only involved in a part of the system. Once the charging network is sufficiently developed they can refinance it using pension fund money and continue to develop more assets.
Finally, don’t return it to shareholders. This shows a spectacular lack of imagination and shareholders don’t really appreciate it either.
It should be highlighted that this solution is not available for all utilities. Those that move quickly have a chance of thriving while those that are too slow may simply disappear.
